by Franklin J. Parker, CFA
The Summary
- The Fed delivered a mixed message last week. On the one hand, guidance hasn’t changed: money-printing is set to end in March, and rates are to stay low until the money-printing is done. On the other hand, there is a growing consensus that March will see at least a 0.25% rate hike, and possibly even a 0.50% rate hike. Powell also acknowledged the challenge with managing the Fed’s balance sheet, and though he did not explicitly say this, I got the sense that the Fed would wait until about mid-summer to begin shrinking their balance sheet. All of this means that the Fed will be a dominant and downward force on market prices until probably August/September of this year, and that will be in a tug-of-war with economic fundamentals, which are improving as evidenced by last week’s GDP print for Q4, which posted at a blockbuster 6.9% (5.5% was expected).
- Personal consumption expenditures decreased slightly for December, posting in-line with expectations. PCE is the Fed’s preferred inflation gauge. With a modest decrease—the lowest print since Feb 2021—markets took this as a glimmer of hope that inflation may be peaking. I remain unconvinced, as this is likely just driven by slowing consumer demand rather than slowing price increases. Recall, my wildcard risk for 2022 is inflation as it can push an economy into a recession by stunting capital expenditures and consumer spending.
- This week we get some insight on the health of manufacturing and services with PMI data. A reading of the labor market, we get JOLTS job openings data and the usual weekly print of initial jobless claims (though that figure has become less important in recent months), and the headline unemployment rate for Jan. All of these are important data points. I am watching closely for clues on the health of the overall economy, and all of these figures are key on that front.
The Details
The Wall Street Journal reported today that Ukraine-Russia tensions have pushed up wheat prices (though it does appear the upward trend began years ago). I have been talking about my concern for increased tensions for the past few months. But, how concerned should investors be from the perspective of their portfolios?
First and most important: markets do not like uncertainty. War (or a regional conflict) is among the most uncertain things that markets can experience. In general, then, the potential for hostile actions simply adds to volatility and will tend to depress prices.
That said, it appears unlikely that the US and her allies would risk an open war with a nuclear-armed Russia. It has been the policy of the United States to avoid open wars with nuclear states at all costs. Though I must admit my non-expertise in this area, I see a US war with Russia as a very low-probability scenario.
Even if the US and her allies are not involved, hostilities still disrupt the lives of millions of people, cut off trade routes, and disrupt production in the areas around the conflict. This is obviously bad for economic activity.
Furthermore, the US and her allies have indicated they would impose crippling sanctions on Russian oligarchs as well as Russia herself. While US trade with Russia is relatively insignificant (Russia is the US’s 26th largest trading partner with about $35 billion in goods traded per year), Russian trade with the European Union is much more significant. Russia is the EU’s 5th largest trading partner (and the EU is Russia’s largest trading partner). More importantly, Russia supplies over a third of the natural gas used by the EU.
In other words, sanctions, though painful to Russia, are also painful to Europe. Europe is already struggling with economic growth and inflation, and sanctions are sure to exacerbate those problems. This regional conflict, then, could be the straw that breaks the camel’s back, pushing Europe into a recession.
Chart of the Week
Market volatility is back! Although, much of what we have seen is normal, we just forgot because the Federal Reserve has been pulling volatility from markets for the past decade. The recent bounce in markets has led some to question whether the selloff is over. While it is very, very hard to predict these things, my view is that we have a bit more downside to go.
In the chart below, I have plotted my baseline case for the S&P 500. I expect March/April to be the bottom, and I expect the S&P 500 to be down 15% to 20% at the bottom. It is not uncommon to see a bounce after hitting an important milestone (down 10%), but there is still significant overhead resistance for markets around the 4500 level. Unless markets push above that level with some conviction, I do not believe the recent bounce has escape velocity.
Again, short-term swings are notoriously hard to predict, so I may well update my view as new data and market action comes in.
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